LONDON, July 18 (IFR) - A European Central Bank led probe
into the health of the region's banks is likely to uncover a
host of non-performing loans that could be the final undoing of
Europe's most vulnerable financial institutions.

Banks across Europe could face capital holes worth billions
of euros once the ECB introduces a stricter and Europe-wide
definition of non-performing loans (NPLs) and launches what is
in effect an external audit of the sector.

"Banks will not be able to massage these numbers or hide
NPLs. They will have to take it very seriously. This is the ECB,
after all," said a senior DCM banker.

The ECB is currently preparing a comprehensive review before
it undertakes the stress tests scheduled for March 2014.

Investors are attaching a lot of weight to the ECB's
supervisory powers, as they believe that the central bank, like
the Federal Reserve, will have no interest in conducting a
half-hearted assessment.

To add to the credibility of the stress tests, bankers say
the ECB may prevent regulators from evaluating their own
country's institutions.

"Having a central process to what is essentially an external
audit will certainly help its credibility. And if the ECB mixes
the regulators up to ensure they are not assessing their own
banks, the market will attach more weight to their results,"
said Neil Williamson, head of EMEA credit research at Aberdeen.

It may work out, for example, that a Portuguese regulator
will be responsible for assessing a French bank. This should act
as a deterrent to regulators overlooking weaknesses, bankers
say.

"For a long time certain banks have been relying on favours
from their university mates that are in top positions within
their central banks. This has destroyed the credibility of
previous tests," said one senior debt banker at a US bank.

STRONGEST ON TOP

"The stress tests are likely to highlight the gap between
the strongest and the weakest banks in Europe, and in turn,
investors are going to want a higher premium to take on the risk
of some of these less fortunate institutions," said Robert
Montague, a senior financials analyst at ECM Asset Management.

This will be an unfavourable outcome for European regulators
who are desperately trying to create unity and nurse the weakest
banks and countries back to health.

MORE BAD LOANS

The ECB certainly has a mammoth task ahead of it.

Non-performing loans are a cancer on a bank's balance sheet
- reducing lending capacity, consuming capital and making
investors more risk averse simply by their presence.

And data released over the past month shows that NPLs in
Spanish and Italian banks are actually increasing.

Spanish banks' bad loans as a percentage of total lending
rose to 10.9% in April from 10.5% in March, according to the
Bank of Spain. That proportion is expected to increase further
as a difficult economic outlook weighs on the capacity of
households and companies to repay debts.

Similarly, NPLs in Italian banks grew by 22.4% to EUR135.7bn
over the past year, according to data from the country's banking
association ABI.

The figures should not come as a shock given widespread
concerns about peripheral countries over the course of the
crisis, but the combination of a clearer definition on NPLs and
stronger regulatory oversight will hit hard.

"The stress tests are likely to uncover capital shortfalls
in weaker banks," said Lee Tyrrell-Hendry, a macro credit
analyst at RBS Markets.

"These shortfalls could be filled internally through
deleveraging, de-risking, asset sales or rights issues, but for
the mid-tier banks in the periphery we think there is a risk of
bail-in of junior bondholders and equity holders."

MORE STRESS

Preparation for the tests already appears to be underway.
This week Commerzbank sold EUR5bn of UK property loans, reducing
its NPLs by EUR1.2bn, although the bank admitted that the sale
had no notable impact on its Core Tier 1 capital ratio, which
now stands at 8.4% - only just above the minimum 8% Basel III
level that systemically important banks are required to hold.

The concern now is that NPLs are reaching crisis point in
the weaker peripheral banks, and their underlying economies are
showing few signs of growth. Last year, NPLs in peripheral banks
reached EUR500bn, according to research from JP Morgan.

Now that the ECB's credibility is at stake, debt experts
believe the upcoming stress tests need to be a lot more - for
want of a better word - stressful.

The last set of stress tests was completed in July 2011 and
only flunked eight European banks to expose a capital shortfall
of a mere EUR2.5bn.

The European Banking Authority allowed banks like Dexia,
Bankia and SNS Reaal to glide through examinations, only for
major weaknesses to be later exposed.

And it failed to spot problems in Ireland, Spain and Cyprus,
all of which led to painful government bailouts, and in some
cases, bondholder bail-ins.

National regulators have been equally lax in their approach,
which bankers and investors claim is partly a result of cosy
relationships.

But that should change in just nine months' time, if the ECB
manages to convince markets that the scrutiny of NPLs is not
only more rigorous, but also truly free from national bias.
(Reporting by Aimee Donnellan, editing by Alex Chambers and
Julian Baker)